Risk-Shifting and the Regulation of Bank CEOs' Compensation
September 3, 2012
Forthcoming in the Journal of Financial Stability
23rd Australasian Finance and Banking Conference 2010 Paper
This paper analyzes the effects of two regulatory mechanisms, namely a regulation of the structure of bank CEOs incentive pay and sanctions for the CEOs of failed banks, on bank risk shifting. We extend a standard model of CEO compensation by incorporating leverage and an investment decision. To the extent that bank depositors and creditors are even partially protected by public guarantees, we show that it is in the interests of bank shareholders to choose more risky investments than would be socially optimal, and therefore to design a CEO contract with excessive risk taking incentives. Thus, we argue that current corporate governance arrangements in the banking sector are not efficient. In this setting, we show that putting in place one of the aforementioned mechanisms could yield the socially optimal outcome at no cost. We also identify some limitations and potential perverse effects of these mechanisms.
Number of Pages in PDF File: 30
Keywords: Banking regulation, CEO incentives, Corporate governance, Moral hazard
JEL Classification: G21, G28, J33
Date posted: August 24, 2010 ; Last revised: September 4, 2012
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